The global economy has suffered a massive hit from the COVID-19 pandemic. The collective impact of disruptions to supply chains and falling consumer demand have caused many businesses to suffer varying degrees of financial stress with some having to recapitalise or refinance. While some M&A transactions on foot prior to the onset of the pandemic have been disrupted or delayed, the impact of the pandemic will open up opportunities for cashed-up funds and other buyers to, in time, take advantage of strategic and investment opportunities presented by the pandemic.
But there is a silver lining to the COVID-19 cloud. Businesses in a relatively strong financial position despite the economic downturn may wish to consider capital management strategies such as share buy backs. It may also be an opportune time for businesses to restructure, rationalise by winding up dormant or unprofitable entities, and to undertake housekeeping in preparation for the divestment of non-core or non-performing operations.
This guide will discuss some of the tax issues that may confront businesses when considering initiatives such as restructures, refinancing, or some of the opportunities that may present themselves in these tumultuous times.
With potentially depressed asset values brought on by the COVID-19 crisis, it may be prudent to consider restructures of operations to facilitate rationalisations or wind up of dormant or unprofitable entities, or the packaging of assets within entities to facilitate future divestments.
Where businesses operate within an income tax consolidated group (broadly, wholly owned Australian resident corporate groups) or a goods and services tax (GST) group (broadly GST registered entities that are commonly owned to at least 90%), transfers of assets (including interests in an entity) within the group may be undertaken without income tax or GST consequences.
Outside of a tax consolidation or a GST group environment, any transfers of assets may trigger gains or losses for tax purposes or a mismatch of GST liabilities and credits. In some cases, where the parties to the transfer are not dealing with each other at arm’s length, or no consideration is given for a transfer, market value consideration may be substituted for income tax purposes although it may be possible to support lower market valuations of assets in the current economic climate.
The stamp duty consequences of any transfers of assets should also be considered. Unless an exemption or concession applies, stamp duty is imposed on transfers of ‘dutiable property’ and acquisitions of ‘significant interests’ in entities holding land interests in excess of a certain value. The rules vary in each state or territory.
Corporate reconstruction relief may apply to an otherwise dutiable transfer and other limited transactions involving members of the same group. What constitutes a ‘group’, pre- and post- association period requirements for the transaction parties, and the extent to which the prima facie stamp duty is waived, vary between the states and territories. However, it is important to note that the relief does not apply automatically – it must be applied for and approved by the relevant revenue authority.
Some specific examples of potential opportunities are discussed in more detail below.
Cross-border transfers of intellectual property
An impediment to the transfer of intellectual property (IP) and intangibles to offshore related parties is often the associated tax cost.
In a post-base erosion and profit shifting world, transfers of IP and intangibles to related parties offshore can still be made where those parties undertake the key value-creating functions such as IP development, enhancement, management, protection and exploitation activities. Regard should also be had to recent guidance provided by the Australian Taxation Office (ATO) in the form of Taxpayer Alert 2020/1, which highlights ATO concerns with certain cross-border non-arm’s length arrangements involving intangibles (see our previous summary of the alert here).
Provided businesses can navigate the ATO’s concerns, there are sufficient commercial drivers for the transfer of IP, and the destination jurisdiction has adequate substance to support IP income streams to that jurisdiction for transfer pricing purposes, it may be an ideal time for businesses to revisit, or consider, cross border IP planning strategies where IP valuations have been adversely affected by COVID-19 such that the tax cost associated with the transfer may be less than what it might have been prior to the pandemic.
Migration of residency
Almost all countries have shut their borders and imposed travel restrictions or bans to curb the spread of the coronavirus. It is still too early to assess the impact of the pandemic on globalisation but, ironically, this may be the best time to consider migrating your residency offshore.
When individuals, trust or companies cease to be Australian tax residents, they are deemed to dispose of all their capital gains tax (CGT) assets for market value except for assets that are ‘taxable Australian property’ such as Australian real property.
It is open to individuals who cease to be Australian residents, but not trusts or companies, to elect to defer any taxing point until such time as they dispose of an asset. This is particularly relevant to the individual owners of Australian corporate groups who are looking to move overseas and, as a result, shift the central management and control of those groups offshore. Those individuals may choose to be taxed on a deemed gain calculated by reference to the market value of the corporate group at the time they cease Australian tax residency. Any further accretion in value of the group would not be subject to Australian tax when the interests in the group are eventually disposed of (provided that the value of the group is not predominantly referable to Australian land). If the individuals choose to defer any taxing point until they dispose of their interests in the corporate group, the trade-off is they may be subject to Australian tax on any further increase in the market value of the group that accrues after they cease Australian tax residency.
Business valuations may have decreased in the current climate such that individuals who are looking to move overseas indefinitely may decide to be taxed upfront on any deemed capital gain as a result of them ceasing to be Australian tax residents. Any further increase in the market value of the business post-cessation of Australian tax residency should not be subject to Australian tax when the business is eventually disposed of.
For completeness, it should be noted that Australian-incorporated companies should not be deemed to dispose of their CGT assets if their central management and control shifts to another jurisdiction, even if this means they become tax resident in that jurisdiction. However, if a business has any foreign-incorporated companies which are currently Australian tax resident, those companies will be deemed to dispose of their CGT assets if their central management and control moves offshore and their voting power is not controlled by Australian resident shareholders.
Demergers and spin-offs
Demergers or spin-offs involve the restructuring of a corporate group by disconnecting part of the group’s business and transferring it directly to shareholders. This would ordinarily trigger CGT consequences for the corporate group and the distribution of the business that is demerged or spun off may constitute a dividend that is included in the shareholders’ assessable income. There are demerger roll-over provisions which, if they apply, allow any capital gain that would otherwise be made by the corporate group to be disregarded, and any dividend to be treated by the shareholders as non-assessable.
There are several conditions that must be satisfied before demerger relief is available. Furthermore, the relief is only available to genuine demergers, which are those directed at restructuring a business in the interests of business efficiency. For example, if a demerger is undertaken to facilitate a sale of the demerged group, the relief may not be available.
If there is a possibility that demerger relief will not be available, corporate groups may still consider a spin-off. Falls in the values of businesses brought on by the pandemic may mean that any capital gain is reduced (or there may even be a capital loss). The business to be spun off can be distributed in specie to shareholders by way of a return of capital and/or a dividend which could be fully franked to the extent there are sufficient franking credits.
Formation of tax consolidated or GST groups
Most Australian resident corporate groups are tax consolidated. However, there are still some groups that have not formed a tax consolidated group due to the adverse tax implications of doing so. For example, the process of setting the tax costs of the assets of a subsidiary member of the group requires the ‘allocable cost amount’ to be calculated. There are eight steps to the calculation of that amount but, for most groups, the first two steps are the key ones being the cost of acquiring the subsidiary member (step 1) and the liabilities of the subsidiary member (step 2).
Where a corporate group has been in place for some time, the step 1 amount may be nominal (for example, it may be the initial paid-up capital of the company). This often means there may be a step down in the tax cost of the assets of the subsidiary member such as depreciating assets or inventory where the market value of goodwill is relatively higher. This is because the allocable cost amount is generally allocated to assets of the subsidiary member in proportion to the market values of those assets.
These groups should revisit the valuations of their assets. Decreases in the market value of goodwill may mean that the allocable cost amount is not skewed away from other assets such as depreciating assets or inventory. Of course, those assets may also have decreased in value so businesses should undertake modelling to assist with the decision on whether to form a tax consolidated group.
Formation of a tax consolidated group may also allow access to losses that would otherwise be quarantined in subsidiary members. The rate of utilisation of those losses may be limited to an ‘available fraction’ but businesses should consider this potential opportunity to reduce tax that would otherwise be payable if a tax consolidated group were not formed.
Formation of a GST group, as is the case for a tax consolidated group, allows for transactions between group members to be disregarded for GST purposes. Whilst GST would normally result in a temporary cost (other than potentially a higher stamp duty liability), GST grouping may alleviate any issues associated with having to initially fund the GST liability amount of an intra-group transaction prior to receiving from the ATO offsetting GST credits. Accordingly, businesses which have not yet formed a GST group should consider doing so independent of any decision to form a tax consolidated group.
Cash flow management is critical for businesses during the coronavirus crisis. This has led to many businesses renegotiating the terms of their finance and/or seeking new sources of finance.
The tax implications associated with financing can be complex. Some questions businesses will need to consider include:
- What is the characterisation of financing for tax purposes? A substance over form approach is adopted under the tax legislation to the characterisation of financing as debt or equity. Returns on ‘debt interests’ are potentially deductible to borrowers while returns on ‘equity interests’ are non-deductible but can be franked.
- What happens if the terms of financing are amended? If the amendments constitute a ‘material change’, the characterisation of a financing arrangement may change from a debt interest to an equity interest or vice versa potentially impacting the deductibility of returns to the borrower or issuer. A related legal question will be whether the amendments to the terms of a financing arrangement are so significant as to result in the cancellation of the arrangement and its replacement with a new arrangement.
- Does the borrower have any withholding obligations? If the lender is a foreign resident, a borrower may be required to withhold from payments made to the lender. This may result in an additional cost to the borrower if the loan agreement requires payments to be grossed up by any withholding tax. Where the payments are interest, Australia’s rate of interest withholding tax is 10% but this may be reduced to nil where debt instruments are offered to the public.
- When are returns on financing assessable or deductible for tax purposes? The timing can differ for the lender and borrower and can depend on factors such as whether the lender is carrying on business as a money lender or the application of the taxation of financial arrangement (TOFA) rules.
- Do the hybrid mismatch rules apply? These rules may apply to deny deductions to a borrower where the financing exploits differences in the tax treatment of the financing under the laws of at least two tax jurisdictions.
- Will any interest deductions be denied under the thin capitalisation rules? These rules, which can deny interest deductions where a business’ debt is excessive, are very relevant in any economic downturn. They are discussed in more detail below.
- What about the waiver or forgiveness of debts? Where a debt is waived or forgiven, the ‘debt forgiveness rules’ may apply to the borrower. Where they apply, those rules could operate to reduce, in order of priority, tax losses, capital losses, certain tax deductions, and the cost bases of capital gains tax (CGT) assets. The lender may be entitled to a revenue deduction or capital loss.
Some specific opportunities and risks in the context of financing or refinancing are highlighted below.
Deductions for lenders
Lenders may be recognising interest on an accruals basis for tax purposes. The renegotiation of loans, or their impairment for accounting purposes, may allow lenders to move to a realisation basis of recognition.
If all or part of a loan is to be waived or forgiven, lenders who are subject to the TOFA rules may also be entitled to a balancing deduction. The calculation has a number of elements such as the face value of the loan, repayments that have been received, amounts to which the lender has already been assessed, and any consideration for the waiver or forgiveness.
Some lenders may have made fair value or financial reports elections under the TOFA rules. Where they hold debt, which is recognised at fair value through the profit or loss for accounting purposes, any increases in fair value are assessable while any decreases in fair value are deductible. A deduction may, therefore, be available where the value of debt has fallen due to the economic impact of COVID-19.
Structuring for equity upside
Lenders may be seeking to obtain the benefit of any potential increase in the market value of a borrower by supplementing debt with an equity stake in the borrower. This can be achieved through convertible notes, or a debt instrument with separate call options over shares. In the latter case, it is important to ensure the options are issued for market value consideration; otherwise the market value of the options could be assessable to the lender. Although there is a provision that can treat the market value of the options as ‘non-assessable non-exempt’ income, it only applies in limited circumstances. The provision of consideration may not necessarily require a cash outlay by the lender – the pricing of the debt, for example, could be adjusted.
While redeemable preference shares could also be considered, as equity (notwithstanding any characterisation as debt for tax purposes), they will be legally subordinate to debt. In this economic climate, it is expected that debt with an equity kicker would be preferred over equity.
Businesses that are foreign controlled or which have foreign operations may be subject to the thin capitalisation rules. One of the tests to determine ‘maximum allowable debt’ under those rules is the safe harbour debt test. This test broadly allows businesses to gear up to 60% of the difference between the value of Australian assets and non-debt liabilities without suffering any denial of interest deductions. The calculation is based on the accounting value of a business’ assets.
If any assets have been impaired for accounting purposes, or have reduced in value, this may mean that a business’ maximum allowable debt as calculated under the safe harbour debt test may be exceeded, potentially resulting in the denial of interest deductions. Where the lender is a foreign resident, interest withholding tax may still be payable notwithstanding any denial of interest deductions.
Options to mitigate the risk of a denial of interest deductions include adjusting the debt/equity mix or considering whether alternative methods under the thin capitalisation rules may allow for a higher maximum allowable debt.
One alternative method is the arm’s length debt test. In broad terms, to satisfy the arm’s length debt test, an entity’s debt must be equal to or less than the notional amount of interest-bearing debt that, assuming arm’s length terms and conditions:
- An entity would reasonably be expected to have throughout an income year; and
- Independent commercial lending institutions would reasonably be expected to lend to the entity throughout the income year.
The assessment of these requirements is based on various assumptions, for example, on the basis that no guarantee, security or other form of credit support is provided to the borrower.
The notional amount of debt is to be determined taking into account factors prescribed in the tax legislation including borrower’s capacity to meet all its liabilities, the borrower’s profit and debt-to-equity ratio, and the general state of the Australian economy.
Loans to subsidiary members of tax consolidated groups
Where a business has formed a tax consolidated group, it typically will have executed a tax sharing agreement (TSA) for income tax purposes. Having a valid TSA in place allows members of a tax consolidated group to avoid joint and several liability for income tax liabilities of the group that remain unpaid after the due date for payment. The validity of a TSA depends on a reasonable allocation of the tax liabilities between members of the group.
A valid TSA can also enable a member to exit a tax consolidated group clear of any future income tax liabilities of the group that, as at the date of exit, were not yet due.
TSAs are typically accompanied by tax funding agreements (TFAs). Since liability to pay income tax attributable to a tax consolidated group rests with the head company, a TFA provides a mechanism for the subsidiary members of the group to pay their allocation of the income tax liabilities of the group to the head company, and sets out the manner in which the funding is to be accounted for.
TFAs may also provide for subvention payments to be made by a head company to a subsidiary member that would otherwise have made a tax loss on a standalone basis. The risk is that lenders to a subsidiary member of a tax consolidated group (without any recourse to the broader group) who is in default may seek to recover any asset of the subsidiary member in the form of a subvention payment owing by the head company. Given the risk of subsidiary members becoming insolvent in the current economic climate, it may be prudent for tax consolidated groups to review debt instruments on issue by members of a group, and the terms of any TFA to identify the risk of lenders being able to make claims against the head company and options to mitigate this risk.
The above comments also extend to loans made to members of a GST group which has in place an indirect tax sharing agreement and an indirect tax funding agreement.
COVID-19 may force some businesses to reassess their debt/equity mix. This may lead to the conversion of debt into equity or ‘debt for equity swaps’. The debt forgiveness rules mentioned earlier apply to debt for equity swaps, which may result in the reduction of various tax attributes of a borrower.
Another important issue to be considered in the context of debt for equity swaps is the share capital tainting rules. These rules apply when an amount is transferred to a company’s share capital account from another account. Where a company’s share capital account is tainted, any returns of capital are treated as unfranked dividends. Furthermore, the tainting can trigger a franking debit to the franking account.
There is an exclusion in the share capital tainting rules for debt for equity swaps where the market value of the shares issued by the company equals so much of the debt that is discharged, released or extinguished in return for the shares. However, the financial stress suffered by many businesses as a result of COVID-19 may mean that the market value of any issued shares falls short of the face value of the debt.
Despite the economic downturn brought on by COVID-19, some businesses are thriving or at least have not been impacted to the same extent as many other businesses. Listed companies who have suffered falls in their share prices but are nevertheless in a strong cash position may wish to consider an off-market buy-back of their shares. Under an off-market share buy-back, the buy-back price consists of capital and dividend components. The dividend component may be frankable so, if the company has franking credits to attach to the dividend component, shareholders are typically willing to have their shares bought back at a discount to market value.
Furthermore, where the capital component of the buy-back price is low (keeping in mind that there are integrity rules that can treat the capital component as an unfranked dividend), shareholders may make a lower capital gain than they would have if they had sold their shares on-market (or may even make a capital loss). In summary, an off-market share buy-back may be attractive to both exiting and continuing shareholders.
Cash flow will be critical for many businesses to survive the economic fallout from COVID-19. As such, it may be prudent for businesses to review entities in their groups to identify any that are unprofitable or loss making. These can be wound up with a view to ceasing activities that are draining cash reserves or other financial resources. Some entities may simply be dormant in which case these could also be closed down as part of a rationalisation process with a view to minimising ongoing compliance costs.
Where an entity is a subsidiary member of a tax consolidated group, the entity can be deregistered or wound up without any income tax consequences due to the operation of the ‘single entity rule’. Assets to be retained can be transferred to other members of the group without any income tax consequences.
Where an entity is not a member of a tax consolidated group, winding it up or deregistering it is a much more complicated exercise. In the case of a company, distributions on liquidation are deemed to be dividends where they represent income or deemed income. There may be exemptions for distributions of some amounts such as capital profits that are pre-CGT. CGT consequences can also arise on the final cancellation of the shares.
Care should be taken with liabilities of an entity to be wound up that may be assumed by, or novated to, related parties or simply forgiven as these transactions can result in adverse tax consequences under various provisions of the income tax law. In some cases, balancing gains or losses may also arise where the entity is subject to the TOFA rules.
Preparing for a sale
M&A may be quiet as buyers and sellers assess the long-term implications of the COVID-19 crisis. But if the global financial crisis of 2007 is any indication, markets and deal activity will eventually recover and there is no shortage of cashed-up funds and other buyers who will be looking at strategic investments and other investment opportunities.
Businesses which are potentially looking to sell should also consider conducting a preliminary health check of their existing tax compliance or a more comprehensive vendor due diligence. This will enable mitigation of any identified areas of tax risk, amendment of prior year tax filings where necessary, or rectification of weaknesses in the tax function well ahead of any sale process thereby placing the business in a much stronger negotiating position.
Some deals may have been scrapped or delayed following the onset of the pandemic. The tax treatment of transaction costs should be considered under various provisions.
Costs are unlikely to be deductible upfront as they would likely be considered capital in nature. However, a review of the costs should be performed to determine if any can be deducted under other provisions for tax-related costs or as blackhole expenditure over 5 years.
Difficulties associated with accurately valuing businesses in these uncertain times may lead to parties to a transaction structuring some of the consideration as an earnout arrangement.
There are rules that provide for specific CGT treatment of the sale and purchase of CGT assets (including shares in companies or interests in trusts) involving earnout rights being rights to future payments linked to the performance of a business after sale. Key features of those rules are:
- The rules do not apply to all earnout rights, only rights that meet the requirements to be ‘look-through earnout rights’.
- The value of look-through earnout rights is not included in a vendor’s capital proceeds at the time of sale of a CGT asset. This should be contrasted with the position where the rules do not apply in which case a vendor may be taxed on the market value of the earnout right upfront.
- Purchasers should only obtain cost base for earnout rights in a CGT asset they have acquired (e.g. shares in a target company) when actual payments are made under the earnout arrangement. Where the earnout rules do not apply, a purchaser may include the value of the earnout right in the cost base of the CGT asset from the outset.
- Amendments to prior year tax returns may be required where earnout payments are made or received in a year of income following that in which disposal of the CGT asset occurred. This may require amendments to allocable cost amount calculations where the target joined a tax consolidated group.
In the era of COVID-19, many businesses will be confronted with similar issues such as the need to refinance, the forgiveness of loans, or the wind up of non-profitable or underperforming operations. Appropriate structuring of these transactions can assist in mitigating any adverse tax consequences and/or facilitating optimal tax outcomes.
However, it is also important to not lose sight of the opportunities that present themselves in these uncertain times. The ability to shift residency of a corporate group (and its owners) offshore, implementation of a global IP holding structure, or an off-market buy-back of shares are just a few examples of transactions that businesses might consider but are by no means intended to be exhaustive.